9/23/2008 @ 3:35PM

Bailout Auction Far From A Sure Thing

If the Paulson plan passes, the real action begins. Can the Treasury actually pull off the biggest Dutch auction in history?

The Treasury Department’s plan to buy up to $700 billion of mortgage-related assets from banks rests on an auction process that has yet to be tested at such a magnitude in such a short span of time.

Auctions, of course, are nothing new for the Treasury. It holds regular auctions of Treasury bonds with primary dealers, a group of 17 major banks and financial firms, to keep money flowing through the banking system and financial markets.

The Treasury’s single price auctions help set the prices and yields of government debt, the idea being to find the most efficient price that satisfies both buyers and sellers. In a single-price auction, according to the Bureau of the Public Debt, all successful competitive bidders and all noncompetitive bidders get securities at the highest yield of accepted competitive bids.

In the bank rescue plan proposed Saturday, the Treasury would be the buyer, not seller, of securities. In this case, academics said, a reverse, or Dutch, auction might work better. In a Dutch auction, the Treasury would announce the type and amount of security it is buying, and sellers would post their prices. The offers would be ranked in descending order and filled at the last, or lowest, offer.

Anyone who has bought or sold on
eBay
is familiar with the Dutch auction process, as are those who bought the initial public offering of
Google
shares in 2004.

A broad-scale Dutch auction for hundreds of billions of dollars worth of toxic mortgage assets weighing on bank balance sheets could help resolve the pricing issues that are preventing banks from selling them. The lack of any market–there are plenty of buyers but very reluctant sellers holding things up–is one of the reasons why the Treasury and the Federal Reserve are riding to the rescue of the banking system.

In theory, “the government can and should make a profit,” off such an auction, says Robert Hansen, the senior associate dean at Tuck School of Business at Dartmouth. “There is a tremendous opportunity for buyers.”

Getting banks to sell is the tricky part. Some lawmakers want to attach punitive provisions to the plan that might scare away bank participation.

But more fundamentally, banks are too afraid to put their assets up for bid, fearing they’d get the worst possible price. The wide difference between this “fire-sale” price and the security’s unknown value long term, or the “held-to-maturity” price, is what is forcing continued write-downs and stress in the system.

The Treasury proposes to buy up mortgage holdings and then turn around and conduct a second auction to sell them back to the market at that hold-to-maturity price. Treasury Secretary Henry Paulson explained at a Senate hearing today that the department would focus on one type of asset at a time, perhaps starting out with the simpler structures and then moving on to the more complex.

Fed Chairman Ben Bernanke, in the same hearing, said auctions “could be designed to give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets.” He argued in favor of opening the auctions up to as many sellers as possible. “To make this work, we do need flexibility in design of mechanisms for buying assets and from whom to buy,” Bernanke said. “I think you restart this market and then you see the fundamental values.”